10 Essential Legal Rules for Independent Contracting

10 Essential Legal Rules for Independent Contracting

Whether you already hire contractors or are doing so for the first time, there are legal rules for independent contracting you need to know in order to stay on the right side of the law. Both the IRS and US Department of Labor have a pesky tendency to audit or investigate private firms from time to time if they suspect that the company is hiring contractors vs employees, if you're using the wrong paperwork, or reporting activities in the wrong manner. In cases like Uber, sometimes the contractors themselves band together in class action suits to settle the issue.

These trends have sent many gig economy platform operators in particular scurrying to update their contracting terms and documentation. If you're a boutique to midsize VC or PE firm, potential class actions by disgruntled contractors aren't typically a big concern. The IRS or DOL, though, might flag discrete cases or field the occasional complaint from a regularly employed contractor who's being left out when it comes to benefits, stock options or incentive bonuses. When these are given to a firm's salaried staff working on the same project, feathers can ruffle. Here's a rundown of the ten legal rules for independent contracting that you should commit to memory if you want to avoid problems.

1. The IRS assumes that a worker is an employee unless you can prove otherwise.

In other words, independent Contractor status is the exception, not the rule. If the IRS questions a worker's classification during an audit, the burden of proof is on you to prove their independent contractor status.

2. There are many cited "tests," but in the end the IRS looks at 3 major factors to determine a worker's status.

  • Character of the relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Is it a continuing relationship, and is the work performed centered on a key aspect of the business?
  • Financial controls: Are the business aspects of the worker's job controlled by the employer, or the contractor?  This includes things like how payments are remitted, whether expenses are reimbursed, and who provides the equipment or supplies.
  • Behavioral control: Does the company control how the job gets done - i.e., what methods are used, and whether working hours are specified?

Usually, no single factor is used to make a determination. Rather, the IRS will look at the entirety of factors.

3. On-boarding paperwork for independent contractors vs employees is relatively simple.

The only new hire paperwork you need for an independent contractor consists of these three items:

  1. Form W-9, to provide a taxpayer identification number. If you have a valid taxpayer ID number for a contractor, you do not have to withhold federal income taxes from payments to the contractor. If you do not have a valid taxpayer ID number, you must withhold federal income taxes. This is called backup withholding.
  2. A copy of the independent contractor's resume or C.V.
  3. A copy of the contract.
BEST PRACTICES TIP: Keep the items above in a file for the contract worker, in case of audit.

4. Paying a contractor is much simpler than paying an employee.

Whatever payment terms you and the contractor agree on are acceptable - hourly, by retainer, or by the job. In most situations, you don't need to withhold income tax, FICA taxes (Social Security and Medicare), or Workers Compensation.  

DO note this exception: You must withhold federal income taxes ("backup withholding")  from independent contractor payments if the contractor has not provided you with a valid tax identification number.

5. Contractor pay is reported annually on Form 1099-MISC.

Form 1099-MISC for reporting contractor pay reporting is similar to Form W-2 for employee pay reporting. Form 1099-MISC must be given to the contractor by the end of January, and submitted to the IRS by the end of February.

6. Independent contractors must pay their own self-employment taxes.

Since the companies they work for do not withhold Social Security/Medicare taxes (FICA taxes) from their pay, independent contractors must pay self-employment tax based on total income from self-employment each year. This offsets a full 15 percent of the pay they earn from you, since they pay both employer and worker shares of the SS tax. This, and having to cover their own insurance and other costs, accounts for the higher hourly rate most contractors charge.

7. Independent contractors can be any business legal type.

Typically an independent contractor is a sole proprietor, but the contractor can be organized as any type of business including an LLC, partnership, or corporation. Depending on the type of work the contractor performs, a limited liability entity makes sense for many situations.

8. If you've only ever used contractors, you might have a safe harbor.

Internal Revenue Code Section 530 established a "safe harbor" for employers; under this provision, a company is not liable for employment taxes if it can demonstrate a reasonable basis for treating workers as independent contractors, show consistency in treating all workers the same way, and keeps a good paper trail. There are various ways to show reasonable basis (reasons like, everyone in your industry does it this way, or your business advisor told you it was okay).

9. Agreements help clarify expectations for independent contractors.

Having a written contract is pretty basic. While you can hire under an oral agreement, it does help to have something to show to a regulating agency if it comes looking. The IRS does not look at the contract as "proof" that the worker is a contractor, but it helps both you and the contractor understand expectations and the nature of the relationship.

10. You can always ask the IRS if you're not sure.

You can ask the IRS to give you a determination letter to clarify independent contractor status. Use IRS Form SS-8 to request a determination. Once you complete and submit the form, the IRS will respond with a letter giving their opinion on the status of this worker (employee or independent contractor). Graphite has sample consulting agreements, W-9 Forms and Nondisclosure agreements in our Resources section for your convenience.

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